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High Stock Complacency

The US stock markets have been surging in one heck of a January rally. The combination of the fiscal-cliff tax deal and generally solid Q4 earnings have propelled stocks to their best levels in 5 years. But these gains have been accompanied by stellar complacency. Traders are extremely bullish, convincing themselves this rally is only beginning. But high complacency near major highs really means serious downside risk.

As of the middle of this week, the flagship S&P 500 stock index (SPX) was up 4.8% month-to-date. Over halfthese gains came on January’s opening trading day, on great relief that Obama’s record tax hikes were averted for most Americans. The SPX then kept on marching higher on decent Q4 earnings, hitting 8 new cyclical-bull highs in just 13 trading days! It’s on track for its best January performance since 1997.

These new highs have naturally unleashed a torrent of new bullishness. Investors are happily expecting continuing gains as far as their eyes can see. They aren’t the least bit worried about any potential selloffs, a dangerous emotional state known as complacency. The dictionary defines it as “a feeling of contentment or self-satisfaction, especially when coupled with an unawareness of danger or trouble”.

As contrarian trading theory documents, the great majority of investors want to buy after major rallies. They feel the best when stocks are already high, when greed runs rampant. The public especially is notorious for flooding into stocks after long runs when they are carving major new highs. But buying high is super-risky, because once a surging market has already sucked in all near-term buyers only sellers remain.

As an ethereal herd emotion, complacency can’t be measured directly. But it can be inferred through long-established sentiment indicators. The best are based on the options-trading concept of implied volatility. Traders buy options to bet on future market moves. By analyzing their collective trades, we can get a read on how fast they expect the stock markets to move in the near term over the coming months.

The VIX is the most famous implied-volatility index, and is often known as the “fear gauge”. Fear is a far more immediate and potent motivator than greed, so markets are much more volatile when traders as a group are scared. So in practice the higher options traders’ implied volatility, the more scared they are. And greed occupies the opposite end of the sentiment pendulum’s arc from fear, a low-volatility environment.

Complacency is closely intertwined with greed, so low volatility betrays high complacency. While the VIX is fine, I still prefer its original incarnation now known as the VXO. It is the classic VIX from before this index’s calculation methodology was heavily modified in 2003. While the new VIX looks at near-term S&P 500 options, the classic VIX looked at near-term at-the-money S&P 100 options. It was more responsive.

During sharp stock-market selloffs, the biggest and most-liquid stocks are sold first on the heaviest volumes. They can much more readily absorb the selling pressure while minimizing adverse price impact, giving big traders more favorable exit prices. The S&P 100 is the top 20% of the S&P 500 stocks in market-cap terms, the ones hit hardest and quickest whenever a wave of selling hammers the markets.

This first chart looks at the VXO implied-volatility index over the past 4 years with the SPX superimposed on top. Even if you are bullish like everyone else these days, there is simply no arguing the fact that low VXO levels (inferring high greed and complacency) inevitably precede major selloffs. Despite all the newfound enthusiasm out there, today’s stock markets are in a very dangerous place with big imminent downside risk.

The VXO is always very low near major stock-market highs. This was the case in April 2010 when this fear gauge fell to 14.3 just a few trading days before the SPX topped ahead of a major 16.0% correction. Again in April 2011 the VXO fell to 13.5 just before the SPX started plunging 19.4% in the second major correction of its cyclical bull. This longstanding market pattern of low volatility indicating major toppings continued.

In March 2012, the VXO fell to 13.4 just a week before the SPX started slumping in a major 9.9% pullback. Then again in September 2012, the VXO hit 12.4 on close a week after the SPX started sliding in a large 7.7% pullback. This pattern is crystal-clear. Whenever complacency surges to major highs as indicated by exceptionally low implied volatility, the stock markets are topping just before a major selling event.

Each of the high-complacency episodes of this cyclical bull saw slightly lower VXO lows which formed the descending support line rendered above. The longer a bull exists, the less traders worry about it ending so general fear levels bleed off over time. This also happens within individual uplegs, leading to a decaying VXO pattern I call asymptotic flattening. An asymptote is a line approached but never reached.

After any major selling event, a pullback (less than 10%) or correction (more than 10%), fear initially bleeds off rapidly as the fast-falling VXO reveals. But as the stock markets continue recovering, complacency graduallygrows. This leads to the curved VXO decay patterns highlighted above, falling fast initially before flattening out for some time before hitting unsustainable fear lows (and complacency highs).

This month’s big stock-market rally was so extreme that it actually broke the VXO well below its entire cyclical bull’s support line! This extraordinary move started on December 31st and January 2nd, when the SPX surged 1.7% and 2.5% on first fiscal-cliff-deal hopes and then the passed fiscal-cliff tax deal. The VXO plunged 20.7% that first day and 27.0% the second, a stupendous 42.1% 2-day fear bleed.

The VXO (classic VIX before 2003) historical data goes back to 1986. In the entire quarter-century history of this preeminent sentiment indicator, it has only plunged 40%+ in 2 trading days one other time. That was back in October 1987 just after that infamous Black Monday stock-market crash. And in order to plunge 40%+ in 2 trading days then, the VXO started at its all-time-record crash-day high of 150.2! The recent fear bleed was truly extraordinary.

And then as more and more Q4 earnings were released in this past week, complacency as measured by the VXO continued soaring. It closed at fresh new cyclical-bull lows of 12.1, 12.0, and 11.8 in recent days. As the chart above shows, we’ve never seen such low fear and high complacency in this entire cyclical stock bull! This means an imminent major selloff is nearly a certainty, a very-high-probability event.

If the 4-year-old cyclical bull remains alive and well as everyone assumes, this selloff will at least be a sharp correction like the ones seen in mid-2010 and mid-2011, closer to the large end of the correction continuum. So if you read nothing else I write, at least gird yourself and prepare your portfolio for a sharp SPX selloff in the high teens in percentage terms. Such corrections greatly damage those unprepared.

But I suspect this coming selloff will ultimately prove much worse than a correction. The next step up is a newcyclical bear market. These beasts tend to cut stock prices in half over a couple years, so they are not to be trifled with. And they always begin in periods just like today, near major stock-market highs marked by hyper-complacency when everyone assumes the bull market will continue powering higher indefinitely.

The primary argument for this new-cyclical-bear thesis is the stock-market cycles, which I explained in depth inan essay back in October. Stock markets are cyclical, alternating between great 17-year secular bulls and 17-year secular bears driven by valuations. Our current secular bear began in early 2000, and we aren’t out of the woods. 17 years haven’t passed yet, and stock valuations haven’t fallen to bear-ending levels (7x earnings) yet.

Within the long sideways grinds of secular bears are smaller cyclical bears and bulls. The former cut prices in half as mentioned, while the latter then double them again. The result is a long horizontal trading range. In our current secular bear, for the SPX this trading range has run between secular support near 750 and secular resistance around 1500. And that’s right where the SPX is today.

It is challenging 1500 this week, the top of its secular-bear range. Both in 2000 at the top of the last secular bull, and 2007 at the top of the last cyclical bull, cyclical bear markets were born near 1500 on the SPX. And adding to the relentless selling pressure secular-bear resistance exerts, our current cyclical bull is both much larger than average and has lasted much longer than average. It is overdue to give up its ghost.

Since March 2009, the flagship S&P 500 has powered 120.9% higher over 47 months as of this week. The average size and duration of mid-secular-bear cyclical bulls in modern times is around a doubling over less than 35 months. So with our current cyclical bull already far larger and older than expected, the odds are mounting that it has to yield to the next stage of the perpetual bull-bear cycles very soon.

Another evidence this bull is growing tired and running out of steam is how its latest highs have been won. After initially topping in early April 2012 at a much more typical 109.7% gain over 37 months, the stock markets ground sideways to lower for the next 5 months. They didn’t finally break out to new bull highs until first the European Central Bank and then the Fed both launched unprecedented open-ended debt-monetization campaigns in rapid succession in September.

Despite stock traders eagerly waiting well over a year for each of these highly-anticipated inflationary easings, the best the SPX could muster were modest 2-day rallies for each event. It only climbed 2.5% after the ECB bond-buying pledge neutralized the European debt crisis, and just 2.0% after the Fed made history with its unprecedented QE3 campaign. Despite these awesome buying catalysts, the SPX was merely up 3.3% in just over 5 months.

And just a couple trading days after the Fed’s stunning QE3 announcement, the top-heavy SPX started drifting sideways to lower again. Not even the mind-boggling QE3 expansion the Fed announced in mid-December, potentially the biggest Treasury monetization in history, could lift stock prices out of their funk. New cyclical-bull highs weren’t seen again until early this month, just after the fiscal-cliff tax deal was signed.

Realize that Obama wanted to nearly triple dividend taxes to 44.8% on high earners, something that would have likely shattered investor psychology. So the new fiscal-cliff tax deal’s permanent rates of 15% for those earning less than $200k per year and 23.8% over $400k (20% plus an additional 3.8% Obamacare tax) was a vastly better outcome than the worst-case scenario. Buyers flooded back in relief.

Now no one would argue these catalysts were not huge. First the ECB pledged unlimited bond buying to stem off the festering European debt crisis, an unprecedented move. Then the Fed launched its first-ever open-ended debt-monetization campaign, something that will never again have as much impact psychologically as at its initial birth. And the recent tax fears and resulting compromise were utterly unprecedented too.

Each of the new cyclical-bull highs in the SPX since last April was driven by extraordinary and unrepeatablecatalysts. The stock markets have only edged to new highs, which weren’t much better in percentage terms, on incredibly bullish and one-off catalysts. This is a sign of a very top-heavy and tired cyclical bull market. How on earth will it continue advancing when hyper-bullish catalysts cease?

Are you aware of any on the immediate horizon? Not me. Sure, earnings can be decent but the lion’s share of Q4 earnings season is almost over. We still have the sequester government spending cuts coming, the epic debt-ceiling fight, and the battle royal over Obama’s record overspending that is rapidly plunging our country into a debt crisis. All these things are bearish catalysts, not bullish ones.

So all of this coupled with the highest complacency of this entire cyclical bull argues overwhelmingly that the coming complacency-sparked selloff will mark the vanguard of a new cyclical bear. But even if it doesn’t, a major correction is in the works. So be very careful buying into the vast majority of stocks these days with the stock markets at such precarious highs. The coming selloff will suck in almost everything.

So how did low-VXO indications of hyper-complacency factor into the last cyclical bull’s topping in October 2007? Similarly yet differently. Before that first cyclical bull of this secular bear failed and rolled over, the vast majority of traders refused to believe we were even in a secular bear. So the last cyclical bull was much less volatile, with lower overall levels of fear and higher complacency throughout its entire lifespan.

The VXO followed its usual asymptotic-flattening decay curve during the last cyclical bull too, which ultimately drove it to lower prevailing levels since general fear was lower earlier in this secular bear. Provocatively the VXO hit its bull low of just 9.1 in January 2007, well before that bull peaked in October 2007. This precedent leads some to argue that the VXO at 11.8 today is no big deal, it can still go lower.

While anything is possible, I’d still be extremely careful. Today we are 6 years deeper into the secular bear than when the terminal year for the last cyclical bull began. Vastly more traders are aware of the secular bear and its implications today, so lower fear and higher complacency levels are far less likely. In addition, the US didn’t face a crushing European-style debt crisis then like it truly does today. A sub-10 VXO is extremely unlikely this time around.

And although the last cyclical bull’s topping was uncharacteristically choppy which drove much higher bull-killing volatility than normal, the SPX still closed at 1440 that day the VXO hit its bull-market low. Though the SPX would ultimately top at 1565 less than 9 months later, that would immediately be followed by a brutal cyclical bear culminating in a once-in-a-lifetime stock panic. The SPX plummeted 56.8% in that bear!

So yes, a cyclical-bull VXO low doesn’t guarantee an imminent topping. Stock markets can still drift higher on momentum in some circumstances after new VXO lows. But even if they occur a little early, the high complacency does eventually spark major selloffs. It truly isn’t worth the serious downside risk to buy into a major stock-market topping when the dominant fear gauge has fallen to bull-killing levels. The odds for success are wildly out of buyers’ favor.

Despite all the bullish hype out there and traders blissfully not having a care in the world, today’s stock markets are extremely dangerous. Complacency is out of control, a sentiment extreme that never lasts for long. So investors buying high in this environment are taking on mammoth risks. Even if the bull market persists, which is increasingly doubtful, the low VXO reads herald an imminent major correction at best.

So what can investors do? I’d argue buy something with proven performance in this secular stock bear’sprevious cyclical stock bears. And that happens to be gold. This precious metal thrives as an alternative investment when stocks are under sustained selling pressure. It is cheap and out of favor today, leading to incredible contrarian buying opportunities in the universally loathed gold and silver stocks.

At Zeal we’ve been very wary of the high stock-market levels, high complacency, and well-past-its-sell-by date cyclical stock bull. So we’ve been loading up on carefully researched hand-picked high-potential gold and silver stocks, the ones with the best fundamentals. They are a rarity today, a sector where it is easy to buy lowsince everyone is as convinced they are doomed as they are certain the recent SPX rally is just beginning.

For well over a decade, we’ve published acclaimed weekly and monthly newsletters helping contrarian speculators and investors navigate this tricky secular-bear market to big profits. In them I draw on our vast experience, knowledge, wisdom, and ongoing research to explain what is going on in the markets, why, and how to trade it with specific stock trades as opportunities arise. Since 2001, all 637 stock trades recommended in our newsletters have averaged annualized realized gains of +33.9%! Subscribe today!

The bottom line is despite popular wisdom, the stock markets are extremely dangerous today. Not only are they at secular-bear resistance, complacency is as high as it’s been in this entire cyclical bull. And the recent new bull-market highs were begrudgingly driven by extraordinary unrepeatable bullish catalysts, not ordinary profits growth. Those buying today are assuming enormous downside risks.

The absolute worst time to buy general stocks is when fear as measured by implied volatility is extremely low. Such high-complacency times herald imminent major selloffs, sharp corrections even in ongoing bull markets. And with today’s cyclical bull defying the averages for size and longevity, the odds of a new cyclical bear are higher than ever. Foolishly buying general stocks heading into a bear will decimate your wealth.

About The Author

Zeal LLC was founded in early 2000 as a pro-free market, pro-capitalism, and pro-laissez faire contrarian investing and speculating Information Age financial-services company. Our principals are lifelong contrarian students of the markets who live for studying and trading them. We employ innovative cutting-edge technical analysis as well as deep fundamental analysis to inform and educate our subscribers on how to grow and protect their capital through all market conditions. We have an unquenchable zeal for the markets.